Welcome to Invesco Mortgage Capital Inc. Third Quarter 2018 Investor Conference Call. All participants will be in a listen-only mode until the question-and-answer session. [Operator Instructions] Now I would like to turn the call over to Brandon Burke, Investor Relations. Mr. Burke you may begin to call..

Thank you and good morning everyone. Again, we welcome you to the Invesco Mortgage Capital third quarter 2018 earnings call. Management team and I are delighted you've joined us, as we look forward to sharing with you our prepared remarks during the next several minutes before we conclude with the question-and-answer session.

Joining me today are John Anzalone, our Chief Executive Officer; Kevin Collins, our President; Lee Phegley, our Chief Financial Officer; and Dave Lyle, our Chief Operating Officer and Brian Norris, Interim Chief Investment Officer. Before we begin, I'll provide the customary forward-looking statements disclosure.

This presentation and comments made in the associated conference call may include statements and information that constitute forward-looking statements within the meaning of the U.S.

Securities Laws, as defined in the Private Securities Litigation Reform Act of 1995 and such statements are intended to be covered by the Safe Harbor provided by the same.

Forward-looking statements include our views on the risk positioning of our portfolio, domestic and global market conditions, including the residential and commercial real estate market, the market for our target assets, our financial performance, including our core earnings, economic return, comprehensive income and changes in our book value, our ability to continue performance trends, the stability of portfolio yields, interest rates, credit spreads, prepayment trends, financing sources, cost of funds, our leverage and equity allocation.

In addition, words such as believes, expects, anticipates, intends, plans, estimates, projects, forecasts and future or conditional verbs such as will, may, could, should and would as well as any other statement that necessarily depends on future events are intended to identify the forward-looking statements.

Forward-looking statements are not guarantees and they involve risks, uncertainties and assumptions. There can be no assurance that actual results will not differ materially from our expectations.

We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions, Risk Factors, Forward-Looking Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations in our annual report on form 10-k and quarterly reports on Form 10-Q, which are available on the SEC website at www.sec.gov.

All written or oral forward-looking statements that we make or that are attributable to us are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate.

To view the slide presentation today you can access our website at invescomortgagecapital.com and click on the Q3, 2018 earnings presentation link, you can find on the investor relations tab at the top of our home page. There you may also select either the presentation or the webcast options for both the presentation slides and the audio.

Again, welcome you and thank you for joining us today. And I will turn the call over to our CEO, John Anzalone.

John?.

Good morning and thank you for joining Invesco Mortgage Capital third quarter earnings call. I'm pleased to report core earnings of $0.41 cents and a positive economic return of 1.1% for the third quarter.

Book value is relatively stable during the quarter down 1.3% and the impact of higher rates in wider agency spreads was partially offset by tighter spreads on seasoned credit.

As Brian will discuss in more detail in a moment, we are quite active during the quarter repositioning the portfolio out of lower yielding seasoned15-year and Hybrid ARM agencies into newly issued 30-year agencies and agency CMBS. Taking advantage of the very attractive return profiles offered in those sectors.

Since the repositioning took place over the course of the quarter, the full impact was not fully reflected in the third quarter. This repositioning sets us up well for the future as we expect our core earnings remain relatively stable in the coming quarters.

We feel strongly that active management and our ability to invest across many different types of opportunities within the mortgage market are going to be the keys to successfully navigate in this environment. Our investment activity has been largely has been concentrated largely in the agency's space this quarter.

We still have about half of our equity invest in residential and commercial credit. I'd like to take a moment to discuss our views on credit. As you'll see later in the presentation, our credit book is very seasoned in the underlying collateral has had the benefit of years of property price appreciation on average.

This book would be nearly impossible to construct today, particularly if the book yields were later added and remained extremely comfortable holding these positions. We expect fundamentals to continue to support these investments even as we move later in the credit cycle.

However, given relatively tight spreads across much of the residential and commercial credit sectors, the term profile has become relatively less compelling and we prefer to invest in agencies were current ROEs are quite attractive. This also allows us to stay liquid and gives us the opportunity to take advantage when credit assets cheapen.

Our ability to make tactical asset allocation decisions across sectors is the reason we place so much value on the flexibility offered by the hybrid restructure.

While agency spreads have been under some pressure as rate volatility has picked up and the impact of the Fed's balance sheet reduction settles and we do believe that agencies will hold up well when broader credit markets experienced periods of spread widening pressure.

Of course, while adding agencies reduces our credit risk, it also introduces moderation and convexity risk.

This is mitigated by our security selection as we have added prepaid protected specified pool collateral and locked out agency CMBS as well as by an active risk management process which has led us to reduce our duration exposure by adding more hedges as we've increased our agency allocation.

I'll stop here and let Brian talk about the portfolio in more detail..

Thanks, John. I'll start on slide six, which provide the breakdown between agency and credit exposures in our portfolio, both on an equity and total asset basis. As you can see, we remain well-diversified across sectors with a modest uptick in equity committed to our agency book increasing from 48% on June 30 to 51% as of September 30th.

This is largely due to the redeployment of proceeds from our commercial loan pay downs into the agency book. As ROEs on both agency RMBS and agency CMBS improved given spread widening in the first half of the year.

Overall leverage increased modestly quarter-over-quarter to 6.4 from 6.1 as average earning assets increased over $600 million due to the redeployment of the unleveraged commercial loan pay downs into levered agencies and CMBS. Moving on to slide seven. I would like to highlight the repositioning of our agency RMBS book during the quarter.

We sold approximately $2.9 billion of seasoned agency RMBS pools. The majority of which were in the 15-year and hybrid ARMs sectors. We reinvested the proceeds into higher yielding 30-year low payout specified pools as hedged ROEs improved during the first half of the year given the sharp widening in the 30-year sector to 13% to 14% range.

The improvement in book yields on the redeployment was notable, as the yields on purchases were 1.5% to 2% higher than the bonds we sold given their seasoning. Prepayment speeds remain well contained and we expect to see some benefit as speed slow down as winter seasonal impacts take hold.

We continue to see accretive investment opportunities in 30-year fixed rate agency mortgages with hedged ROEs over 14% given additional widening in the sector in October and we'll continue to act on opportunities to increase the earnings power of the portfolio while maintaining our disciplined approach to risk management.

Turning to slide eight for a few brief comments on our growing agency CMBS book. We purchased $440 million a predominately 10-year agency CMBS during the quarter which brought our total exposure to the sector close to $600 million as of 930.

Agency CMBS as a nice complement to our agency RMBS assets, given the prepayment protection embedded in the securities in the form of prepaid penalties and lockout provisions.

Spreads tightened during the latter half of the quarter reducing our activity, but it widened back out to attractive levels in the fourth quarter allowing us to purchase an additional $100 million in October. The widening occurred in sympathy with AAA CMBS credit bonds as heavy supply from the GSE pressured spreads and hedged ROEs are now around 12%.

Moving on to commercial credit on slide nine. Fundamentals in commercial real estate remain positive as growth in the broader economy continues to support property valuations. Our CMBS portfolio consists of a combination of well-seasoned single-A and BBB bonds financed via Repo and AAA and AA bonds finance at the federal home loan bank.

While tighter credit spreads in the third quarter made it more difficult to find accretive opportunities in CMBS. We continue to find pockets of value in the sector and purchased $167 million of subordinate CMBS during the quarter with ROEs in the low teens.

Our commercial loan portfolio continues to run-off with a balance of $32 million at quarter end and a weighted average maturity of about two years. Slide 10, highlights the credit quality of our commercial portfolio. The chart on the left shows the average LTV of our CMBS assets which has continued to improve and a down to approximately 35%.

The chart on the right highlights the seasoned nature of our CMBS book with over 80% in the 2014 vintage or earlier.

Positively, spreads on seasoned subordinate bonds are benefiting from increased investor demand due to rating agency upgrades, contracting spread duration, embedded property price appreciation and in some cases deleveraging from loan pay downs. Slide 11, covers our residential credit portfolio.

This portfolio remains well diversified with 42% of assets in the GSE CRT paper, 37% in legacy bonds and Re-REMICs and 21% in post-2009 Prime paper. Spreads tightened notably in the sector during the quarter primarily CRT and Legacy's.

Fundamentals are also strong here as economic strength and healthy consumers are helping to offset declining affordability due to the rise in home prices and mortgage rates.

As you can see from the chart at the bottom of the slide, durations are very low across the portfolio and with the majority of our holdings paying a floating rate coupon earnings in this sector are largely protected against higher funding costs.

During the quarter, we funded an initial investment of $45 million and a loan participation interest secured by mortgage servicing rights with a commitment to fund an additional $30 million over the next two years. The transaction serves as another example of our ability to provide shareholders with access to unique investment opportunities.

Slide 12 provide some detail around the credit quality of our residential credit portfolio. 72% of our CRT investments have been upgraded by at least one rating agency since issuance as shown on the chart on the left. The upgrades are a result of significant underlying home price appreciation and low default rates.

The chart on the right reflects the vintage distribution of our investments.

Our legacy positions consistent Prime and Alt-A paper that we purchased relatively early in the recovery high book yields while our CRT positions are concentrated in earlier post crisis vintages which had higher credit quality and lower spread volatility the newly issued securities.

Since quarter end, we have been able to take advantage of spread widening and attractive financing in CRT selectively adding bonds and the 11% to 12% ROE range which is particularly attractive given the floating rate coupon. I'll end on Slide 13 with financing and hedging.

At quarter end, we had $14.4 billion of repo outstanding with 29 counterparty and $1.7 billion of secured financing to the Federal Home Loan Bank. To reduce the risk associated with changes in repo funding costs, we held $9.9 billion of interest rate swaps which we increased by $1 billion during the quarter.

In addition to our interest rate swaps, we increased our Treasury futures position during the quarter to $1.5 billion, up from $285 million on June 30th. Since quarter end, we have added $500 million of interest rate swaps and $500 million of Treasury futures notional to protect against higher funding costs and interest rates.

Higher funding costs are further mitigated by $1.9 billion book variable rate assets which effectively pushes our heads ratio of near 75%. As we move through fourth quarter, we will continue to actively manage our portfolio to optimize our earnings capacity while limiting the impact of higher interest rates. That ends my prepared remarks.

Now we will open the line for Q&A.

Thank you. We will now begin our question-and-answer session. [Operator Instructions] First question from Doug Harter from Credit Suisse. Your line is open..

Hey guys. This is Josh on for Doug. First on the $45 million loan participation in MSR, can you talk a little bit about the ROEs that you are expecting from that investment? Thanks..

Yeah, hey this is Dave. I can provide a little more detail around that. We are able to get repo funding to further benefit returns on that loan participation agreement. It's fairly modest, but with that additional leverage we expect ROEs on that investment in other 13% to 14% type range..

Got you through it. And then, just one more, given the spread moves we've seen in the fourth quarter, are you guys able to give us a sense as to your book value performance quarter-to-date? Thanks..

Yeah, sure. This is John. Yeah we're down a little bit less than 3% quarter-to-date. And yes, basically a combination of wider agencies spreads and impact of higher rates credit spreads or maybe modestly wider, but that impacts a lot less..

Awesome. Thanks for the comments guys..

Sure..

Thank you. Next question from Eric Hagen from KBW. Your line is open..

Thanks. Good morning.

On the decision to rotate out of the seasoned agency MBS, can you just give me a little color, I mean, I guess, my sense is that seasoned collateral typically has some sort of prepayment -- favorable prepayment characteristics that presumably have some value and I can appreciate kind of rotate out of this for the higher yield that you captured, but just kind of walk me through how you balance the prepay characteristics versus the yield that you capture on the backend? Thanks..

Sure, Eric. Thanks. This is Brian. The bonds that we sold were, like I said, primarily 15-year and hybrid and certainly 15-years do have stronger prepayment protection versus kind of new issues 30-years.

But those bonds were purchased between three to six years ago at much lower yields and have held in really well as rates rose and spread widened particularly in 30 years. So we felt like the third quarter was a really good time and opportunity time to rotate out of those sectors and into prepay protected 30-year newly issued specified pools.

And agency hybrids in particular are going to face some more issues going forward, particularly as the curve continues to flatten and borrowers are rotating out of hybrids and into fixed-rate collateral. Q - Eric Hagen Got it. Thanks.

And then on hedging, I mean the CMBS, I mean the Freddie K, I mean are those when you guys kind of think about the construct of your hedging profile? I mean, are those bonds being sort of hedged for -- there is no prepayment kind of sensitivity or very little anyway.

Are you hedging those bonds I guess is kind of the most direct question or is it really just kind of the agency RMBS that we should sort of think about as sort of the hedged piece of the portfolio with swaps?.

Sure. This is Kevin. The short answer is yes, we're hedging those and I will expand on that a bit and say that one of the reasons we like them is that they're very easy to hedge, just given that they have minimal extension risk relative to say agency MBS..

Got it. Okay, as you think about growing the portfolio potentially, I mean, you guys talked about attractive returns.

Where do you think about adding new hedges? What part of the curve is what I'm asking?.

I will start there and others can add. I think just looking at different tenures of swaps, very short swaps don't make a lot of sense because there really isn't a whole lot of uncertainty around short rates in the next three to six months here.

On the other end, it doesn't very long swaps aren't particularly appealing as well as there isn't a lot of value in extending well beyond the remaining expected life of the said hiking cycle.

So somewhere between say two or three years maybe on the tail of that is probably the sweet spot because it really covers the uncertainty around the magnitude of further hikes from the fed in the next couple of years. We can still take advantage of locking in them to create greater visibility around earnings by doing this.

Those types of swaps and really as opposed to making a very defined call on what we expect to happen the rates we're able to kind of position the portfolio to be successful across a range of potential outcomes..

And I would add that when we look at our hedging book, there's two different aspects to it. I think there is the hedging your net interest margin which is having swaps that offset the impact of Fed rate increases which we see through higher repo costs which I think Dave is mostly talking about [indiscernible] talk about swaps.

But also when we look at our book value protection, we're looking much more holistically with the portfolio about hedging across the entire interest rate spectrum and making sure our key rate duration exposures are where we want them to be. So it's really two parts to that.

So I think from that we're putting our swaps, I think Dave is absolutely right we're targeting sort of that maybe middle of the curve, sort of that belly of the curve I guess if you will and then we use Treasury futures to target more directly where we want to put our hedges for sort of book value protection..

Yeah, that's helpful color. Thanks. Last one on just kind of hedged and levered ROEs that you guys quote especially on the credit side.

I mean, are we -- I just want to make sure I'm clear that we're talking about kind of the coupon interest and any premium amortization or just description and not any sort of expectation for price appreciation or spread tightening that's factored into that kind of that yield that you quote?.

That's correct. It's the form and we don't assume any kind of spread tightening to get to those ROEs..

Okay. Thank you, guys. Thanks for the comments..

Thank you. Next question from Steve DeLaney from JMP Securities. Your line is open..

Good morning. It's nice to be back on with you John and your team. Noting the CMBS investment the $400 million in the quarter, agency CMBS, can you tell us what percentage is Fannie Mae does versus Freddie K.

I heard you mentioned Freddie K, but had not heard you mentioned Fannie bonds?.

Sure. This is Kevin. Just note there that we focused at this point all on Freddie K in terms of that employment in agency CMBS..

Okay. Got it. And historically you working with other parts of Invesco, you guys have long had the capability of making CRE three whole loans whether it's senior or [indiscernible] over the years, but it looks like that portfolio maybe the loan portfolio may be run off you're down to $32 million as is shown on page 10.

Am I reading that right that anything you want to express on commercial credit, you're going to use CMBS rather than whole loans at least for the near-term?.

Yeah, I guess -- this is Kevin again and I would say that know big picture, we entered the direct commercial real estate loan origination business in 2013. And you kind of go back to that time period, we were doing it when very few were originating loans.

And as you can see with what it's left us with in terms of commercial real estate loan portfolio that's throwing off around a 10% yield on levered currently. So it's been a really nice an attractive return for us. I think, what's changed is that competition's become pretty fierce there. I don't think we've seen a lot of flexibility in credit terms.

That said, we have seen a notable contraction in your premiums. And as a result, you've seen our loan portfolio continue to decline because we haven't run a risk adjusted basis found it to be as attractive. So it's not to say, we won't continue to look at opportunities there we certainly will.

We're just going to be a lot more selective about where we compete because in contrast if you think about CMBS it's always been a really nice way to lock in a rate hedged net interest margin.

But doesn't just constantly force you to go out and reinvest into what is a flattening goal curve and that's because unlike a lot of those floating rate commercial real estate loans where you are recycling capital it's always coming back to you have the benefit of prepayment protection in CMBS.

And you can go back in time, so to speak and invest in exposure -- find exposure to loans that were originated several years ago which means they're using underwriting that was arguably more conservative as well as appraisals that were notably lower than where properties are going to be valued today.

And so we think that that gives us a bit of benefit as well..

Great color. And….

I add one little piece too is that being part of a larger organization, we don't really face the same sort of cost structure in terms of entering and exiting that business as some of our peers might. So you don't see us taking like being cost to exit or enter so we can kind of be selective about our entry points into that market..

Understood. You’re not having to underwrite an entire platform every time you decide to crank it up. So appreciate I that color. And my last one, didn't hear much about on the residential side beyond CRT and legacy.

Is there anything in the evolving residential whole loan market specifically thinking non-agency in QM type paper? Are you watching those markets and the private RMBS market to evaluate whether there's anything for you to do there in the near term?.

Yeah. Hey, this is Dave again. We certainly are -- we spent a lot of time looking at non QM, re-performing loans securitizations, NPL, single family rentals we cover all those sectors and invests in those sectors as a platform.

But in a levered vehicle like IVR really just with a combination of available yields and available funding in terms of repo haircuts and financing. They're not particularly attractive relative to other opportunities that we have. I would say for non-QM single family rental, it's probably about 7% and 9% type ROE right now.

So again we're seeing better opportunities agency MBS, CMBS and kind of on the edges of CRT and Prime 2.0..

Thanks. I appreciate all the comments..

Thank you. [Operator Instructions].

All right, I would like to thank everybody for joining us and we’ll -- until next quarter..

Thank you. That's concludes today’s conference. Thank you for joining. You may now disconnect..